The equitable doctrine of ‘marshalling by apportionment’ — and why lenders may wish to know about it
The Victorian Supreme Court has recently clarified an area of law otherwise ‘not highly defined or clearly stated’:[1] the equitable doctrine of ‘marshalling by apportionment’. In the case of Callisi Pty Ltd v Sterling & Freeman Advisory Pty Ltd,[2] M Osborne J addressed competing arguments regarding the application of the rule of equity capable of impacting the ability of a first-ranking secured interest-holder to realise its security across multiple assets.
The issue
Marshalling by appointment is relevant to a situation where there is a first-ranking secured creditor with security over multiple assets and, below it, two or more equally-ranking secured creditors with respective interests in one or other of those assets; the lower-ranking secured interests are susceptible to the superior creditor seeking to realise its securities in one or more of the assets to which those other creditors otherwise would have recourse. Put another way:
[T]he vice protectable by the principle’s application is that subordinate interest holders of equal standing should be protected from their securities being rendered valueless by the whim of the primary security holder.[3]
How might the issue arise?
Picture a scenario, as M Osborne J did by way of illustration in his Honour’s judgment, which involves the following:
A borrower owns two properties, ‘Whiteacre’ and ‘Blackacre’. The properties are valued at a little over $1 million each.
The borrower mortgages both properties to Lender 1 in exchange for a loan of $1 million.
The borrower later mortgages Blackacre to Lender 2 as security for a loan of $500,000.
The borrower also has several unsecured creditors.
If the borrower defaults, Lender 1 is entitled to realise its securities in whatever order it chooses, even if this might prejudice Lender 2 in its recourse to Blackacre to the extent Lender 2 cannot realise the full amount of its security; the security which Lender 2 held in Blackacre would be rendered worthless if Lender 1 were to exhaust the net proceeds of that property in satisfying part of the debt owed to Lender 1. In such a situation, Lender 2 might need to seek to recover money owing to it by resort to the borrower’s other assets but, in doing so, Lender 2 would need to compete with other unsecured creditors.
At this point, in certain situations, Lender 2 can invoke the ‘marshalling’ doctrine so as to allow Lender 2 to resort to Whiteacre to realise any secured amount outstanding after it has first exhausted its share in Blackacre. This can occur despite the fact that Lender 2 never had a secured interest in Whiteacre.
If, however, the facts were such that the borrower had also mortgaged Whiteacre to Lender 3 to secure a loan of a further $500,000, the situation becomes more complicated. Unlike the scenario involving only Lender 1 and Lender 2, in circumstances where Lender 3 effectively ranks equally with Lender 2 — albeit in respect of different secured assets — ‘equity will not permit Lender 2 to rely on the marshalling of securities in such a way as to allow Lender 2 by the same subrogation type process to stand in Lender 1’s shoes with respect to Lender 1’s interest in Whiteacre, because to do so would prejudice Lender 3’.[4]
How does ‘marshalling by apportionment’ operate?
In the kind of scenario described above, what assistance can equity offer? As his Honour stated:
If it is the case that Lender 1 is able to realise its first ranking securities in whatever manner it wishes, are the fates of Lender 2 and Lender 3 simply left to the whim of Lender 1?[5]
The answer, the Court held, is that the doctrine of ‘marshalling by apportionment’ — as opposed to regular ‘marshalling’ or ‘marshalling simpliciter’, as his Honour described it,[6] and as otherwise might apply where only Lender 1 and Lender 2 are involved — applies. The result is as follows:
Apportionment operates to ameliorate the risk of prejudice to subordinate security holders with equal ranking securities as a result of the order in which the primary security holder chooses to realise the securities. Whilst the primary security holder is free to sell whatever security it wishes to sell, it otherwise should be indifferent as to which security recourse is had, to satisfy its debt. In order to prevent the return to the subordinate security holder being dependent solely on the choice of the primary security holder, an equity arises in favour of each equal next ranking security holder, such as to deem the first ranking security to have been satisfied on a rateable basis.
If the relevant principle is accepted as operating in this way, then what is critical is that there are two creditors with equal ranking securities each of whom stands to be affected by the decision as to the order of sale chosen by the primary security holder. It is the effect on these equal ranking securities which enlivens the relevant equity which is relevantly unaffected by other securities that one or more might hold.[7]
In the scenario illustrated above, while Lender 1 would be free to realise its first-ranking securities in whatever manner it wishes — whether by resort to the proceeds of sale of one particular asset or another — those equally ranking below Lender 1 hold an equitable right — a (mere) equity — which effectively restricts Lender 1 to satisfying liabilities owed to it on a pro-rata basis.
Also, in holding that marshalling by apportionment reflects an equity ‘which is relevantly unaffected by other securities that one or more might hold’, his Honour rejected the contention that a lower-ranking secured creditor should not be entitled to the relief afforded by the rule in circumstances where that creditor holds secured interests in two or more of the assets in question. To use the example illustrated above, it should not matter when applying the doctrine that Lender 2, with a secured interest in Blackacre, also has a secured interest in Whiteacre (albeit ranking lower than its interest in Blackacre).
Calculating on a rateable basis
On the facts before it, the Court calculated the entitlement of the defendant as first-ranking creditor (akin to ‘Lender 1’ in the above scenario) as follows:
The Court calculated the total value of the secured properties — here, there were two with a value totalling $4.43 million.
The Court then calculated the value of each of the two properties as a proportion of the total value — here, one was worth $3.25 million, which equalled 73.36 percent of the total value, and the other was worth $1.18 million, which equalled the remaining 26.64 percent.
The Court then applied those ratios to the value of the debt — here, $3,298,039 — such that 73.36 percent of that debt could be deemed to be recoverable from the more valuable property and the remaining 26.64 percent of the debt could be deemed to be recoverable from the other property.
Having calculated the amounts which the first-ranking creditor could be deemed to recover from the two properties, an amount was then available to the plaintiff (being a lower-ranking secured creditor akin to either ‘Lender 2’ or ‘Lender 3’ in the above example) in relation to the property of which it was second mortgagee.
The plaintiff had sought an order for a lesser sum than the amount which the Court in fact had calculated, and his Honour ultimately considered it appropriate to limit the amount awardable to the sum which the plaintiff had claimed.
Conclusion
Unlike marshalling in the typical sense — the kind which acts as a saving grace to a lower-ranking secured creditor by allowing it effectively to jump forward in order of priority through recourse to an asset in which it never held a secured interest — marshalling by apportionment focuses, in a way, on the rights of a first-ranking secured creditor; it limits that creditor’s freedom to recover money owed to it by recourse to any one or more of the assets in which it holds an interest. The Court’s decision, and the clarity it arguably now gives to the rule, may be worth the attention of lenders.
[1]: Across Australia Finance Pty Ltd v Kalls (2008) 14 BPR 26, [22] (Bryson AJ).
[2]: [2023] VSC 300.
[3]: Ibid [115].
[4]: Ibid [10].
[5]: Ibid [12].
[6]: Ibid [108]. His Honour did note that ‘[w]hether it is regarded as a separate doctrine or as a species of marshalling does not matter’: [109].
[7]: Ibid [110]–[111] (emphasis added).